In his book  “A Mathematician Plays The Stock Market” John Allen Paulos tells the story of a man and his wife, who travel to Las Vegas to do some sightseeing, and do a little conservative gambling.

After a long night out, and losing $1,000 dollars, the man wakes up to find a $5 chip sitting on the hotel dresser. He thinks of it as some magical sign or omen, jumps out of bed and runs down to the casino floor, in such a hurry that, he doesn’t even change out of his green bath robe. He ran to the nearest roulette table and threw the chip on  to the red seven, which hit and paid 35-1 on his $5, or $175. He then continued to gamble and put the winnings on another single number, which in turn hit, leaving him with $6125. He continued like this for another two wins, leaving him with $7.5M. The casino would not take another wager,  saying that they could not afford that payout if he were to hit again. The man ran to the nearest casino that agreed to take the bet. He threw the money on number 8 hitting once again. Ecstatic the man decides to let the £262M ride, only to lose it all on the next spin.

He left the casino and began to walk back to the hotel room where he met his wife who was waking up and asked “Where have you been?” The man replied that he had “Been playing roulette downstairs for the morning.” His wife then responded “How did you do?” The man casually replies “Not bad, I lost 5 bucks.”

This is an example of mental accounting, which was defined by Belsky and Gilovich in 1999 as “ the  inclination to categorise and treat money differently depending on where it comes from, where it is kept, or how it is spent.”  The bloke in the green dressing gown had lost a huge sum of money. But in this exaggerated example, he never really saw the money as his, and so was reckless and cavalier with it. The loss didn’t really hurt. There’s more to this than academic interest or an amusing story though.

It’s well documented, for example, that people gambling using a credit card place bigger bets than when they’re using cash. The money is the same, but the source makes a difference. Even if you’re not a gambler, you probably recognise the truth of this – it’s less painful to pay for something using a card than it is paying with cash. Totally irrational, but none-the-less a reality for a great many of us.

Let me give you another manifestation of this:

You set out to buy a takeaway meal. It’s a windy day, and as you take your phone out of your pocket, you pull out a £10 note with it, and it blows away and down a grate. Gone. You walk into the take away  and buy your meal for £10. How much has the meal cost you? Most people would say it’s cost £10, and perhaps you’d agree. Assuming you had enough money, you’d certainly continue with the plan to buy the takeaway.

Now imagine that you get to the takeaway unscathed, buy your meal for £10, but on the way out, trip up and tip everything out on to the pavement before taking a bite. You have to go back in and buy the same meal again if you want to eat. How much will this meal cost you?  Most people would say it will  cost them £20,  and may well decide not to buy it as a result. And yet the financial consequences of both visits to the takeaway are exactly the same. Logic would therefore suggest that both situations are viewed, and reacted to, in exactly the same way. In reality, that won’t happen for most people.

This is a huge and fascinating area which straddles the fields of psychology and economics, but I bring it to your attention for its practical applications to you, both as an individual and a business person.

As an individual, it’s worth giving some thought to what extent you use mental accounting in your day to day life, and whether a more rational  and consistent approach to money would have a positive effect on your finances. By all rational measures, money is money. It’s source, place of keeping and intended purpose is not relevant to its value or how easily you should part with it.

Moving swiftly from gamekeeper to poacher, as a business person, it’s useful to know that your potential customers usually have a number of sources of money, and they are unlikely to treat each of them in the same way. They are attached to some money (cash, earnings and funds with a pre-determined purpose  for example) much more strongly than other money, such as winnings, Paypal balances and credit card balances.

When businesses look at ways to increase sales, they usually look at the offer they’re making, their product and their pricing. But they  rarely consider how they might exploit the mental accounting of their customers, and tap into sources of funds which are valued less highly, and are more easily accessed as a result.

If you have a business or money making enterprise, it could be worth giving some thought to this.  I’d be interested to hear how you think you might be able to use it.